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How Indexing Distorts Investment Reality

Index funds’ growth brings investing into uncharted territory

Is indexing the perfect investment solution for the majority of investors—or is it the most dangerous threat to free markets since Communism? Is the investment management business an intelligent way for an investor to access expertise—or is it a collection of greedy and incompetent thieves? Like most things in life, reality is somewhere between the extreme portrayals that tend to inhabit the media, and taking time to peel away the more nuanced layers is a valuable and productive exercise.

Modern stock market history has no precedent for the current influence indexing has on investor behavior and attitudes. Indexing is reshaping the public discussion about how to invest. Its simplicity, academic pedigree and remarkable track record have elevated it well beyond a mere investment strategy or even philosophy. I don’t think it’s an exaggeration to conclude that for a growing percentage of participants indexing is now the lens through which they experience and interpret investment reality.

Conventional wisdom informs us that the goal of active investing is to outperform the market. After all, if you can’t generate above-average returns, what’s the point of using professional management? This is a logical, sensible, even obvious conclusion. There is however, one small problem: outperforming the market is not a goal—outperforming the market is a result. And that seemingly infinitesimal, inconsequential, semantic, angels-dancing-on-the-head-of-a-pin difference is what has led investors, investment managers and most of the investment world down a proverbial rabbit hole.

The other side of that rabbit hole is an alternative reality where in order to keep their jobs, investment managers put aside what they know to be legitimate and successful investment strategies in order to chase the chimera of regularly outperforming their benchmark. This is not a little thing. The stakes are massive: trillions of dollars of investors’ capital, and billions of dollars of fees to those managers who can successfully and consistently beat their benchmarks.

Unfortunately, the most sensible and successful long-term investment strategies can be volatile and/or produce long stretches of poor returns—a legitimate headwind in a world where under-performance is treated with growing impatience and the presumptive threat of investors departing with their assets.

Those threats have actualized: In growing numbers, investors have been departing active managers. According to Morningstar, through Nov. 30 all but $1 billion of the $41 billion investors added to U.S. equities in 2013 went to Vanguard. In the competition for investors’ hearts, minds and dollars, the indexers are winning, and their lead is increasing.

The longer something works, the more likely that we will conclude that the elements behind its success are persistent and that the benefits can be assumed to be reliable. As a result we don’t think twice about the following common refrain: “With the exception of a handful of investment geniuses (Warren Buffett, Seth Klarman, Carl Icahn, etc.), everyone else should own index funds.”

An investor’s primary choice is most commonly portrayed as active investing versus passive investing. But that is not correct. The actual choice offered investors is active investing versus index investing. Indexing as an investment strategy is not the same as the index itself, and that is a critical distinction. An index is a mathematical calculation of investors’ aggregate behavior. Indexed investing, like every other investment strategy, impacts and shapes the supply and demand for securities in the market. The more money that is indexed, the more that indexing behavior impacts the market that the indexers are attempting to mimic.

Let me try to put this more plainly: Index investing behavior is not market neutral. The decision to buy or sell any security affects the supply and demand for that security, and thus the price. The fact that indexers have a predetermined mechanical benchmark that dictates what and how much they will buy or sell doesn’t suspend the laws of supply and demand, which shape every transaction that takes place in the markets. And with $3 trillion of assets (and growing) indexed investment behavior is a hardly a fringe issue.

Imagine the kind of media attention that would arise if an active investment manager had $3 trillion of U.S. equities to invest in just one fund. Does anyone doubt that there would be a very public and much extended debate over the potential risks of having so much money concentrated in a single strategy?

Unexpected Upside

I am no apologist for the investment management industry. Firms’ response to the pressure of short-term benchmarking could have been to double down on giving investors the best of what they had to offer, making their case honestly and transparently and letting the chips fall where they may. Instead (with some rare but notable exceptions) the industry chose to pursue strategies designed more to maintain assets than to make the smartest investment decisions—leading (as I argued in my May 2013 column) to today’s sorry state of affairs where indexing has the potential to become so popular it could threaten the stability of the market mechanism it so successfully exploits.

But maybe that’s not such a sorry state of affairs after all. The investment management industry grew into a complacent monopoly pocketing billions of dollars in fees while producing flashy but mediocre investment vehicles. There was no incentive powerful enough to force a change in their behavior until a critical mass of customers realized they could get better results and save 90-95% of the fees they were paying their active managers. So what began as a trickle is turning into a flood. Starting this year, indexing will no longer be a “shot across the bow” of the managed investment industry but a barrage of torpedoes and cruise missiles. Big ships will be sunk.

This raises three simultaneous dilemmas: (1) Everyone can’t index. (2) The active management industry will be increasingly hard pressed to justify charging 10 to 20 times the fees of index funds. (3) If Jeffrey Wurgler of NYU is correct, as index funds continue to grow, even to the point of creating visible impact on the market mechanism, it will be even harder for active managers to outperform them; this will lead even more investors to choose indexing until—well, no one really knows what will happen, but none of the potential outcomes is good.

Even as indexing’s unchecked growth could pose a threat to the stability of the market itself, it is the only force powerful enough to compel the restructuring and repair of an industry long-overdue for a complete overhaul. We should all be grateful to indexing for that.

The environment for the active investment industry is likely to get a lot worse before it gets better. A lot worse. Even so, I’m optimistic that ultimately the outliers in the active investment management industry—those handful of managers and funds that spend their time and energy pursuing excellence instead of asset growth—will form the foundation from which the industry can regroup and finally offer investors truly legitimate and competitive alternatives to index funds. If they can succeed in this forced restructuring, everyone wins.